Tuesday, April 19, 2005

Entitlements Crisis - Part 2

There has been a lot of nonsensical debate about whether there is a social security funding crisis. I guess it depends on how you define "crisis" (apologies to Bill Clinton, who had the same problem with the word "is"). If by crisis, one means that revenues are short of disbursements, we are not there yet. However, if that's the definition, we can't really afford to wait until there is a crisis to do something. So the debate is really about the wrong thing.

The problem is that social security is not prefunded on a sound actuarial basis, as any other defined benefit pension plan is supposed to be. In any private pension, the assets are periodically measured against the present value of all the promised future liabilities. Those future liabilities are discounted at some reasonable interest rate to arrive at the present value. If the present value of future liabilities exceeds the current plan assets, plus the present value of future contributions, additional funding is required.

This was not a problem for social security in its early years. For one thing, promised benefits were reasonably modest. For another thing, there were a relatively large number of workers contributing for every retiree collecting. Projected liabilities were easily covered by plan assets and expected contributions.

However, today, there are about three workers for each retiree, and before long it will be two to one. One of John Rutledge's great lines is that the day will come when every worker will be responsible for his personal "old guy." In addition the benefits package has grown because of COLA's and other enrichment changes. Though revenues still outstrip disbursements, the margin is shrinking fast.

However, there is a crisis by my definition, and that is that the present value of future liabilities is growing faster than plan assets plus the present value of future contributions. This is the slippery slope that we are on.

There are three possible solutions. Raise the social security tax, either by raising the FICA tax rate, the earnings base, or both; reduce benefits or increase normal retirement age; or increase the earnings yield on social security plan assets. The idea behind private accounts is that plan assets invested in mutual funds can earn more than they do invested in Treasury Bonds. This is neither rocket science, nor is it new. President Clinton had the same goal in mind when he suggested that the trust fund invest directly in the stock market instead of Treasuries. Both ideas are better than what we have now, since the earnings yield in Treauries is the low, risk-free rate, and since the Government effectively borrows from the Trust Fund and spends all the money.

As was stated in part 1, there is a hidden agenda in the private accounts proposal, which is to wean social security away from being a social program and make it part of the private ownership philosophy of the Administration. Opponents of private accounts are just as committed to keeping the program purely public.

However, make no mistake. Unless some cataclysmic event, or an incredible amount of youthful immigration occurs in this country, the demographics inevitably point to a problem funding benefits, probably much sooner than is projected. If anything, the administration has understated the problem. The ability to raise FICA taxes is quite limited. The rate is already too high, a combined 12.8% when you count employer and employee contributions. Ask any self-employed person whether they want to see this tax rate increased. The base is also pretty high at 90K. It could go a little higher, but let's remember, this is a payroll tax. When you increase taxes on something, you get less of it. Does anyone want to see payrolls shrink? So the solutions are fairly limited, given the public's revulsion at benefit cuts. Something must be done to earn more on account assets. I don't like the idea that a public trust fund owns shares in private companies, which is what bothered me about the Clinton proposal. So I am in favor of private accounts, though they will not solve the problem at the puny levels the public might accept.

But it's the first step toward a more viable system. In part 3, I'll talk about other steps that should be considered, and then it's on to the real fiscal nightmares this country must face, medicare and medicaid.

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